Markets worldwide tremble at prospect of U.S. ending stimulus policies

WASHINGTON – A wave of selling washed across the financial world Thursday, driving the stock market down, pushing interest rates up and bringing new concern that the forces propping up growth are in danger of fading.

The U.S. stock market closed Thursday down 2.5 percent following a 1.4 percent drop Wednesday — but those declines did not capture the sense of fear that roiled trading floors from Wall Street to London to Tokyo this week. The very underpinnings of a four-year bull market seemed to be coming unglued. An index of expected future market volatility soared 23 percent, to its highest level since the fiscal cliff standoff at the end of last year.

Anxiety was only deepened Thursday by a manufacturing survey suggesting new economic weakness in China — creating a feedback loop in which fear of a global slowdown spooked markets and the teetering markets raised concern about a global slowdown.

But this is not a crisis like the ones which struck the United States starting in 2008 or Europe in 2010. Even amid the chaos, the U.S. economy continues to show encouraging signs — on Thursday, sales of existing homes were reported to be up 15 percent compared to the same time last year.

Rather, the volatility is a byproduct of the world’s central banks, having intervened on a vast scale to deal with the economic travails of the past several years, introducing uncertainty as they start to contemplate how and when the era of easy money might end.

Over the past five years, the Federal Reserve has injected more than $2.7 trillion in newly created dollars into the financial system and is currently continuing to add to that total to the tune of $85 billion a month. But in a press conference Wednesday, Chairman Ben Bernanke made clear that the central bank expects to start pulling back the throttle later this year and ending the purchases entirely by next summer, if the economy cooperates.

That was enough to spark a selloff on bond markets, which drove the interest rate the U.S. government must pay to borrow money to its highest level since October 2011. Those higher rates will soon translate to higher home mortgage rates for ordinary Americans, which could undermine the housing rebound that has been helping the economy get back on its feet. Homebuilders’ stocks fell particularly steeply Thursday.

“The higher rates mean that businesses will also need to pay more for financing their investments,” said Jason Benowitz of Roosevelt Investment Group in New York. “A dramatic rise of interest rates could indeed hit growth.”

In a sign of how interconnected the world’s economies have become, the prospect of the Fed tapering and then ending its actions triggered a flurry of activity in Asian markets. Borrowing costs skyrocketed across the globe, particularly in emerging markets. For example, the cost for the Indonesian government to borrow money for a decade rose more than half a percentage point, to 4.8 percent; similarly eye-popping interest rate increases occurred in countries including Brazil, Mexico, Turkey, Russia and Poland.

Indeed, the Chinese central bank had to launch an intervention of its own to combat the rise in price of money. Bloomberg reported that the People’s Bank of China injected $8.2 billion into that nation’s financial system to combat an abrupt increase in interest rates and unfreeze lending between banks. The weak report on Chinese manufacturing — an HSBC/Markit survey that showed a sharp decline in activity — contributed to a rout in Asian markets.

“I think if it was just the Fed tapering, we wouldn’t see such a negative reaction, because after all it was expected,” said Sam Stovall, chief equity strategist at S&P Capital IQ. “Add on the concern that China is slowing, as the preliminary PMI figures are showing . . . and that bad news usually comes in threes, so the market is expecting some more bad news.”

The signs of economic weakness in China contributed to a steep drop in the prices of global commodities as well. Crude oil prices fell 3.4 percent to $95.14 a barrel Thursday, the price of corn fell 1.8 percent and gold was down just slightly Thursday after a 4.9 percent tumble Wednesday.

The volatility across world markets Wednesday and Thursday had some echoes in what has happened in Japan in recent weeks.

The Bank of Japan has an aggressive plan to try to end a long period of deflation and stagnant growth. The country has seen extreme stock market drops of 7.3 percent and 6.4 percent on separate days over the past month.

One saving grace for the United States: If the market swings really do undermine U.S. growth then the Fed, as Bernanke said repeatedly in his news conference, will move that much more gingerly in removing its help for the economy. Indeed, just Thursday, investors’ expectations for inflation over the next few years fell 0.1 percentage point, to 1.75 percent, the lowest since last July. Because the Fed aims for inflation of 2 percent, that would suggest there is more room for the central bank to pump money into the economy without sparking an outburst of higher prices.

In effect, the Fed mulling an exit from an era of easy money will be a great test of just how resilient the economic recovery really is. It should become obvious whether the whole thing — the rises in stock prices, corporate earnings, the housing market, even in job growth — is driven solely by the flood of money from the central bank, or whether five years of zero-interest rates and trillions of dollars in bonds purchased have succeeded at getting the country’s economic engine up and running.